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Equity Divergence – NASDAQ 100

Background

Divergence is a useful tool in technical analysis. It is a situation where the price of an asset and a correlated indicator move in opposite directions. Divergence highlights a situation where the indicator may be alerting managers that the the factors supporting the status quo trend of the asset are changing and may portend a change in the trend of the asset.

Divergence as discussed here is evident between the NASDAQ-100 (NDX) and two indicators used to measure the underlying supporting strength or health of trend where the asset is an index with a portfolio of equities making up the constituents of the index. The divergence between the index and its underlying constituents was highlighted in a CNBC article Friday November 20th appended to the end of this report.

The divergence between the NDX and the NDX Bullish Trend and Bullish Percent supports the premise of the CNBC article – that the rise in the NDX is being supported by fewer stocks in its constituent portfolio. A warning for managers that the status quo trend of the NDX, positive, is losing support and may be coming under pressure.

Indicators

The indicators discussed here are Bullish Trend and Bullish Percent. These indicators are rooted in Point & Figure Analysis, one of the first methods documented to track and analyze equity prices as far back as the late 1800’s when equity prices were reported via ticker tape machines.

Point & Figure

Point & Figure (P&F) analysis consists of tracking prices using a series of X’s an O’s where X’s are entered for rising prices and O’s for falling prices. Two parameters unique to P&F analysis are required for chart construction:

  • Box Size: The value of each box or how much the value of the asset must change to add an X or O as appropriate to in the current column. This value may be mathematical i.e. $1.00 or it may be logarithmic i.e. 1%.
  • Reversal: This is how much the asset much change for a new column in the opposite direction to be initiated. The reversal is measured by the number of boxes the price must move and thus the box size value must be determined first. Any reversal the analyst believes most relevant may be used. However, the most common reversal is three (3) boxes though one (1) box reversal charts are also very useful.

When analyzing a universe of equities, they may have widely ranging values from a few dollars to hundreds and thus it is appropriate to use logarithmic box size and all analysis in this report utilize a 1% box size.

P&F analysis benefits managers with unambiguous trends and signals, especially when constructed using 3-box reversals as is most common.

  • Trend lines on 3-box reversal P&F charts are drawn objectively at 45-degree angles given the reversal requirements and the requirement for prices to continue making higher highs and lows in positive trends and lower highs and lows in negative trends.
  • Buy signals are unambiguous when a column of X’s exceeds the highest point in a previous column of X’s demonstrating an excess of demand over supply. Sell signals are unambiguous when a previous column of O’s falls below a previous column of O’s demonstrating an excess of supply over demand.

Chart 1 below is 1% box, 3-box reversal of Cisco (CSCO) an NDX constituent stock.

Chart 1 CSCO 1% x 3 Point & Figure Chart, Source: ESignal, Updata Analytics

The trends are obvious and objectively drawn at 45 degree angles. The series of buy and sell signals are evident with the most recent being a buy signal in the upper right of the chart. CSCO is trading in a positive trend with the most recent P&F signal being a buy. This is a positive/bullish situation with demand exceeding supply and contributing to the NDX multi-year positive trend.

Bullish Trend

The Bullish Trend indicator is calculated by drawing the 1% x 3-box reversal P&F charts of every constituent stock in the NDX, adding up the number trading positive trend (P&F charts are either positive or negative trend), and dividing the number of positive trend by the total number in the portfolio and multiple by 100. This yields an indicator from 0 – 100. The higher the number trading positive trend the more stocks that are making higher highs and lows and supporting the rising NDX.

Bullish Percent

Bullish percent analyzes the same 1% x 3-box reversal point and figure charts that are used to calculate Bullish Trend. This time the number of constituent stocks on a point and figure buy signal are summed, divide by the total number of stocks in the NDX, and multiply by 100. This yields an indicator from 0 – 100%. Similar to Bullish Trend the higher the indicator the more stocks on a buy signal supporting the rising NDX.

Bullish Trend and Bullish Percent Examples

Some examples of NDX constituent companies will be helpful to understand how the indicators are calculated and support the index.

Adobe Systems (ADBE) is detailed in Chart 2, a 1% x 3-box reversal P&F chart with trend lines automatically calculated in Updata Analytics. ADBE is clearly in a positive trend with the heavy red bullish support trend line sloping up at a 45-degree angle in the lower right third of the chart.

Chart 2 ADBE 1% x 3 Point & Figure Chart, Source: ESignal, Updata Analytics

Additionally, the most recent signal is a buy signal where the column of X’s exceeded the previous column of X’s at $85.44 noted by the green dashed line in the upper right corner of the chart.

ADBE is counted as both positive trend for Bullish Trend and a buy signal for Bullish Percent.

An example of a constituent company trading negative is Bed Bath & Beyond (BBBY) in Chart 3.

BBBY transitioned from positive to negative trend indicated by the heavy red bearish resistance trend line sloping down at a 45-degree angle in upper right of the chart.

Chart 3 BBBY 1% x 3 Point & Figure Chart, source: ESignal, Updata Analytics

Additionally, the most recent signal for BBBY in Chart 3 is a sell signal on the right side of the chart noted by the column of O’s falling below the previous column of O’s at $56.82.

BBBY is not counted for Bullish Trend or Bullish Percent and is not supporting the rising NDX.

Divergence as discussed here occurs when fewer individual equities are supporting a rising NDX like ADBE in Chart 2 and more individual equities are negative trend, giving a sell signal, or both like BBBY in Chart 3.

NDX Divergence

Comparing Bullish Trend and Bullish Percent to NDX is accomplished by first drawing the NDX daily chart then adding the indicator below and comparing how the portfolio of constituent companies is supporting or diverging from the index trend.

Bullish Trend Divergence

Chart 4 is multi-year chart of the NDX in the top pane and its obvious rising trend with recent volatility in the upper right corner.

The lower pane is Bullish Trend for the NDX constituent companies.

Chart 4 NDX Bullish Trend, source: ESignal, Updata Analytics

Bullish Trend peaked in early 2104 at just over 90 when the NDX was trading at ~3,500. Since then Bullish Trend has declined to 73 while NDX has risen to more than 4,600 in volatile trade of late.

During the past 18+ months the index has risen 33% while the Bullish Trend has declined 19%. This divergence demonstrates fewer companies trending positively, supporting the positive index trend, and perhaps contributing to recent volatility.

Bullish Percent Divergence

Stocks give new buy and sell signals more often than change trends and thus Bullish Percent is a more volatile or shorter-term indicator. The trend of Bullish Percent is less important than comparing how highs and/lows in the indicator compare to the index.

Chart 5 is constructed similar to Chart 4 with a multi-year chart of the NDX in the upper pane and Bullish Percent in the lower pane.

Chart 5 NDX Bullish Percent, source: ESignal, Updata Analytics

The recent peaks in Bullish Percent and the NDX are highlighted by the three (3) vertical blue lines in the right 1/3 of the chart. Each time Bullish Percent makes a lower high the NDX is at or near a recent new high.

This divergence is important as fewer stocks in the NDX constituent portfolio are demonstrating demand in excess of supply and thus fewer companies supporting the rise in the NDX.

Summary

The NDX continues to make new recent highs however fewer stocks within in the constituent portfolio are supporting and confirming those new highs as evidenced by declining Bullish Trend and Bullish Percent.

This declining support for new highs on the NDX merits consideration of the potential for a decline in the index.

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